When the government of Ecuador failed to make a scheduled interest payment on private bonds today, it was hardly the first time a country had defaulted in the middle of a financial crisis. In fact, it wasn't even the first time for Ecuador. The small South American country did so just 10 years ago, at a time when the economy was reeling from natural disasters and a drop in oil prices.
But this default is different. For the first time in history, the government's defense isn't based on an inability to pay. Ecuadorian President Rafael Correa explained rather that he was unwilling to continue to pay debts that are "obviously immoral and illegitimate."
Like many of the victims of the U.S. subprime mortgage mess, the Ecuadorian people were the targets of predatory lending. In the 1970s, unscrupulous international lenders facilitated some $3 billion in borrowing by Ecuadorian dictators who blew most of the money on the military. After the transition to democracy, the Ecuadorian people got stuck holding the bag.
Over the years, the country has made debt payments that exceed the value of the principal it borrowed, plus significant interest and penalties. But after multiple reschedulings, conversions, and some further borrowing, Ecuador's debt has risen to more than $10 billion today.
The human costs are staggering. Every dollar sent to international creditors means one dollar less is available for fighting poverty. And in 2007, the Ecuadorian government paid $1.75 billion in debt service, more than it spent on health care, social services, the environment, and housing and urban development combined.
Correa campaigned on a commitment to prioritize the payment of the "social debt" over financial debt. After taking office in 2007, he responded to demands from Ecuadorian civil society and the international Jubilee Network to form an independent commission to investigate the origins, nature, and impacts of the nation's external debt. While citizens' groups in other countries have carried out their own debt audits, this was the first time a government had supported such an effort.
The debt audit commission documented hundreds of allegations of irregularity, illegality, and illegitimacy in the contraction of Ecuador's debt. In the case of the bonds Ecuador has now defaulted on, the commission alleged that they were issued and restructured illegally, violating Ecuador's domestic laws, U.S. Securities and Exchange Commission regulations, and general principles of international law. The agreement that gave rise to the Global bonds themselves may not be legal under Ecuador's constitution, which prohibits an individual from incurring debt on behalf of the country.
Commercial debt is the most expensive component of Ecuador's portfolio, making up only 30% of its total obligations but comprising 44% of the country's interest payments in 2007.
Correa says he hopes to cut a deal with creditors, much in the way that many U.S. homeowners are seeking to restructure their subprime mortgages. Ecuador's global bonds are currently valued at $3.8 billion. If negotiations aren't fruitful, however, the economic repercussions could be severe.
One avenue for the bondholders would be to sue under the U.S.-Ecuador bilateral investment treaty, which went into force in 1997 (long before Correa took office). Arbitration tribunals, such as the World Bank-affiliated International Centre for the Settlement of Investment Disputes (ICSID), handle such cases. Under this system, there is no public accountability, no standard judicial ethics rules, and no appeals process. A group of Italian investors has a pending ICSID claim over about $5.5 billion in bonds that Argentina defaulted on in 2002.
Investors could also sue in New York courts, as the bonds were issued under the laws of that state. Holders of Argentine bonds have also used that tactic.
Financial analysts have also predicted that Ecuador's default will cut off the country's access to capital markets and could dim its chances of obtaining a long-term extension of U.S. trade preferences, which will expire in 2008.
While the risks of default are high, Ecuador had only two options: keep paying a dubious and possibly illegal debt at the risk of social unrest, or default and face the wrath of the international markets.
This exposes a gaping hole in the international financial system: the lack of an international, independent mechanism for countries to resolve disputes over potentially illegitimate and/or illegal debt or in the case of bankruptcy. Ecuador may be the first developing country to default during the current crisis, but it's unlikely to be the last.
As world leaders seek to build a new international financial architecture to respond to the current meltdown and prevent future crises, they should consider a new debt workout mechanism as one key pillar.
A bill pending in the U.S. Congress would be a step forward. The Jubilee Act, which passed the House of Representatives in 2008, would require the Comptroller General to undertake audits of the debt portfolios of previous regimes where there is substantial evidence of odious, onerous, or illegal loans. The legislation also instructs the Secretary of the Treasury to "seek the international adoption of a binding legal framework on new lending that...provides for decisions on irresponsible lending to be made by an entity independent from the creditors; and enables fair opportunities for the people of the affected country to be heard."
To ensure more responsible and productive lending and borrowing in the future, we need to learn from and redress the errors of the past. Only then can we build the architecture for an international financial system that works for people and the planet.